Description

CCA Industries ("CAW") was written up about on VIC in December 2004 by hack731. Since then, a few things have changed, one of which is that we have clarity on the launch of the Denise Austin line of skin care products (it was a flop). The second thing that has changed is that CAW shares have declined by 15%. In the couple months following hack731's writeup, CAW stock rocketed to the mid-teens, almost hitting $14. It has languished since then, briefly even touching $7 per share this past November. Investors were clearly penalizing the stock as it became apparent that Denise Austin was not going to be the blockbuster that management had hoped for. In fact that company announced its decision to discontinue the Denise Austin line in March 2006. With the stock now back up to $9.59 but still very, very cheap on a relative basis with a great deal of potential to the upside, I thought it made some sense to refresh the idea for those VIC members who are familiar with the story from the initial writeup, as well as to re-introduce it to more recent VIC entrants.

The long and short of this story (mostly long) is that I believe CAW today has earnings power of $1.00 per share, which translates into a price-to-earnings ratio of less than 8x for a branded personal products company that deserves to trade in the range of 15-20x earnings. However this earnings power is masked by a number of inefficiencies that can be ameliorated. In fiscal 2005, CAW posted a headline EPS number of only $0.52. At that level, it's no surprise that the stock is trading where it's trading, which is roughly 18x trailing earnings. However, that $0.52 of EPS masks the true earnings power of the company, which can be crystallized fairly easily and isn't dependent on successful launch of new products, margin expansion, asset conversions or other business contingencies that would be fairly difficult to predict and quantify. Based on the pro forma earnings of about $1.00 per share, the stock deserves to trade in the range of $15-$20, or 56%-108% above the current price. At the same time, the downside is limited by the intrinsic value of CAW's small portfolio of brands, which has been cultivated for many years and could be easily monetized through a sale to small strategic or financial buyers. With slightly more than $60mm in sales in 2005, the brand portfolio should easily be able to attract multiple interested buyers at a bargain-basement price like, say, 0.50x sales, which would translate to $6.65 per share, or 31% below the current stock price, in a worst-case doomsday type scenario. In reality, such worst-case valuation I believe overstates the downside because these brands have the potential to throw off tremendous amount of free cashflow, and I believe could be folded into an existing platform with shared services that could eliminate in the upwards of $10-$20mm of standalone overhead and executive compensation. The company's portfolio has a very healthy gross margin of 65% and requires only about 20% of sales in advertising and marketing expenses, resulting in a potential EBITDA margin of 30% to as high as 45% if the brands are tacked onto an existing back-office platform. Therefore, my doomsday TEV-to-sales ratio of 0.50x quickly translates into TEV-to-EBITDA ratio of under 2x, which is in the realm of the ridiculous. Therefore, I think that, realistically, CAW currently trades very close to a worst-case valuation and significantly below its potential value to a strategic buyer. Alas, we all know that Mr. Market can be highly inefficient sometimes, and that the undervaluation of CAW can continue indefinitely. Still, I believe that the risk-reward profile of an investment in CAW is compelling with an unlikely downside at -31% and upside as high as 100% and I have faith that one day Mr. Market will bestow upon CAW the valuation it deserves.

To steal a pun from hack's first writeup, this story does not have a lot of hair on it; it's fairly straightforward. This is a small, niche-y health and beauty products company with a handful of brands, the biggest of which it wholly-owns (as opposed to licenses). The company is based in East Rutherford, NJ and was founded in 1983 by Ira Berman and David Edell, who still play day-to-day management roles today as Chairman and CEO, respectively. A well-researched profiling of the founding and early beginnings of CAW can be found on the website Fundinguniverse.com (http://www.fundinguniverse.com/company-histories/CCA-Industries-Inc-Company-History.html), and it's a worthwhile read for background and perspective. I won't go through the full business description for this write-up, because I think Hack731 did a good job on that front and I encourage you to go back to his writeup for the business overview. For brevity, it suffices to write that the company owns a dozen or so of key brand lines which it markets and distributes to retail channels. CAW's most important brands are Plus+White (tooth whitening), Mega-T (dietary supplement), Sudden Change (skin care) and Nutra Nail (nail care). Combined, the company's brands generated sales of $63.7mm and EBITDA of $7.2mm in the last twelve month period ending February 2006. Importantly, Mssrs. Berman and Edell own all of the outstanding Class A shares, which enable them to control the board and therefore the fate of the company. This is one corporate governance deficiency that plagues the company, but it's not one that is exclusive to CAW since many companies have dual-class ownership structures. In CAW's case, however, it has somewhat deeper implications because Berman & Co. have a higher valuation hurdle than outside shareholders in an M&A scenario, which could make it very difficult for them to find anyone willing to pay a price high enough for them to give up the company and their rich pay packages. The simple math for this conundrum works this way: Say a Del Labs or a Revlon offers to buy CAW for $15 per share; most shareholders would be happy with a 56% premium today. Berman and Edell, on the other hand, would theoretically have to weigh the benefit of $15 per share (a pay day of about $23mm between the two of them, as they each own more than 700,000 shares) relative to the cost of losing out on sweetheart compensation contracts that in 2005 paid Berman $1.2mm and Edell $1.6mm. Since these gentlemen control the board, these contracts likely won't terminate until and unless they retire or pass away, and are very valuable -- I calculate the present value of the combined pay packages for Mssrs. Berman and Edell is $30mm (discounted at 10%), or $4 for each additional CAW share. However, since this NPV is only valuable to Berman and Edell, they would need to realize the $30mm on only the shares that they own - about 1.4mm shares combined. This translates into a required value per share of $21.00 ($30mm PV divided by 1.4mm shares). Discounted at 6% (and I could make the argument that it should be discounted at only a small spread to treasuries, given that the pay packages are really senior obligations of a healthy business), the PV increases to $42mm or $30 per share (that's 3.6x sales). As much as I believe that CAW shares are undervalued at $9.60, I don't foresee them fetching anywhere near $30.00 anytime soon. This is my long way of saying that while the company can be very valuable to a strategic in an M&A scenario, convincing the control shareholders/management to sell will not be an easy task because of the misaligned incentives. And that is, obviously, problematic.

But I also don't think that a sale is the company's only weapon in its battle to maximize shareholder value. The first catalyst would be a return to normal profitability following a disappointing fiscal 2005. Indeed, last year saw the launch of the Denise Austin line of skin care products, which sold only $3mm of product and probably lost money. CAW discontinued this line in March 2006 and management should be able to refocus on its more successful portfolio of legacy brands, which should restore margins to historical levels. For perspective, EBITDA margins in 2003 and 2004 were 15.5% and 14.9%, respectively. Margins dipped to 11.1% in 2005 and I think it's not unrealistic to assume that the Denise Austin line lost about $1mm and accounted for 200+ basis points of margin deterioration (this is my estimate and has not been vetted with management) . Earnings in 2005 were also negatively impacted by a higher than usual tax rate of 46% due to non-tax-deductible items relating to reserve charges. Adjusted for normalized tax rate of 38% and the Denise Austin losses (which brings EBITDA margins back up to 13.3%, still below 2003/2004), adjusted earnings per share in 2005 were $0.69, much higher than the reported $0.52. On that basis alone, CAW trades at a price-to-earnings multiple of 13.9x. But it gets only better. As hack731 mentioned in his writeup from 2004, CAW has a large stash of cash and marketable securities; as of February 2006, the company had $16.3mm of cash and securities, or $2.25 per share. Excluding interest and dividend income from earnings and backing it out from the share price, CAW's price-to-earnings decreases from 13.9x to 11.3x ($7.35 stock price excluding cash divided by EPS excluding interest income of $0.65). In 2005, CAW's large stash o' cash yielded a measly 2.9% (interest and dividend income divided by average cash and marketable securities balance). This is unacceptable, and it presents an opportunity to create significant earnings per share accretion with a commensurate increase in shareholder value. The company can manufacture an incremental $0.23 of earnings per share by taking its cash hoard (I'm assuming they use $15.3mm, leaving $1mm of cash required to operate the business) and some modest leverage (I'm assuming company draws down fully on its $10mm revolver at a cost of 8%) and commencing a tender offer for as much as 33% of shares outstanding. This scenario creates pro forma earnings of $0.92 per share, as follows:

2005 pro form adjusted EBITDA: $8.1mm
less: depreciation & amortization: $0.3mm
less: interest expense on new debt: $0.8mm
less: income taxes: $2.7mm
net income $4.4mm

current fully diluted shares 7.253
less: shares tendered 2.510
pro forma shares o/s 4.739

Pro forma EPS $0.92
Pro forma P/E 10.4x

Fair value P/E 15x-20x
Fair value per share $13.80 - $18.40

This immensely accretive action should be taken but has not been to date because of the many factors discussed in the previous writeup and the ensuing discussion thread. One of the variables that has held back management from using its cash to better use include a desire to maintain a decent float for the stocks, which makes sense, but only to a point. Another incentive for keeping so cash at CAW is that is acts as an evergreen source of liquidity for Mssrs. Berman and Edell whenever they wish to sell down their stakes (as they have done on a couple of occasions). This goes back to the misaligned interests that I briefly touched on in a preceding paragraph. This has been an unfortunate fact of life for CAW shareholders for a long time, although I imagine change is not impossible but would likely require a large shareholder to step up to the plate and challenge management and the status quo.

The next item on the agenda for maximizing shareholder is management compensation. As mentioned once before, the Chairman and the Board and the CEO, earned total compensation of $1.2mm and $1.6mm, respectively, in 2005. Combined this equates to 41% of EBITDA. by comparison, the Chairman and CEO of Alberto-Culver, another family-owned personal products company, earned $1.3mm and $2.9mm, respectively, in 2005. And Alberto-Culver is about 80x the size of CAW. Why a tiny company like CAW would require both a Chairman and a CEO does not make sense, and it does not make sense that together these two executives suck up 40% of a company's cash flow. It all goes back to the corporate governance deficiencies and the dual-class ownership, but it is egregious nonetheless. To wit, if we exclude the Chairman's compensation, since at a vast number of corporations the Chairman and CEO positions are occupied by the same executive, earnings per share jump to $1.08, which also reflects the tender offer scenario contemplated above. At the current share price, that equates to a P/E of 8.9x pro forma earnings. At this level of normalized earnings, fair value for the stock given a P/E range of 15-20x is $16.20 to $21.60. Returning to the M&A option, a strategic industry buyer (eg, a brand consolidator like HELE or SPC) could easily afford to pay above $15 per share for the company. A strategic would adjusted CAW's EBITDA to exclude the over-compensation for the two patriarchs and could also take out, conservatively, an additional $3mm in accounting, finance, rent and other overhead costs. Even if I assume the buyer would have to agree to pay $1mm per year as 'consulting fee' to Mssrs. Berman and Edell, the savings are considerable and adjusted EBITDA is close to $13mm. At 8x to 9x multiple, that's $16.50-$18.30 per share. The math is as follows:

2005 EBITDA $7.1mm
plus: Denise Austin loss 1.0mm
plus: CEO & Chairman comp 2.9mm
plus: other overhead 3.0mm
less: consultant fee (1.0mm)
adjusted EBITDA $12.9mm

multiple to adjusted EBITDA 8x
TEV $103.6mm
plus: net cash $16.3mm
Equity value $120.0mm
per share $16.54

multiple to adjusted EBITDA 9x
TEV $116.6mm
plus: net cash $16.3mm
Equity value $132.9mm
per share $18.32

Above and beyond the financial engineering of a tender offer or the theoretical valuation in a merger transaction, CAW remains an extremely well-run company. While Mssrs. Berman and Edell are well-paid relative to the size of the company, they appear to be at least deserving of some praise. They have grown sales at a very respectable rate over many years and have done an admirable job of building brand equity for their products, which is reflected in CAW’s pretty impressive margins. Moreover, CAW’s returns on capital are nothing short of phenomenal. In the LTM period ending February 2006, CAW’s return on tangible invested capital (ROTIC) was 57.4%. This compares to an average of 27% for CAW’s much larger competitors: PG at 27%, CL at 47%, ACV at 24% and CHD at 30%, PYX at 29%, and SPC at 19%. I believe tangible capital is appropriate to use in this sector because it excludes the goodwill and intangibles created through acquisition, and many of the larger companies are serial acquirers. Even with industry-leading ROTIC, CCA Industries is trading at a substantial discount to its lower ROTIC peers on a TEV / EBITDA basis:

TEV / LTM EBITDA
CAW 7.4x

PG 15.1x
CL 13.3x
CHD 10.9x
ACV 10.4x
SPC 10.4x
PYX 10.4x
Peer average 11.8x

CAW discount to average -37%
CAW valuation at average multiple $13.86
CAW valuation at 25% discount to average $10.96

Conclusion
CAW’s product portfolio throws of approx. $8mm in EBITDA and potentially much, much more once overhead and executive compensation are stripped out in an M&A scenario. The portfolio generates above-average margins and industry-leading return on capital, and should be very valuable either as a standalone going-concern or to a third party. Furthermore, CAW has an inefficient capital structure and a substantial cash hoard that give it the capability to buy back up to 33% of shares outstanding through a Dutch or similar tender offer, creating significant earnings-per-share accretion and value crystallization.

Risks
• Management continues to milk the business by paying themselves more and more
• Wal-Mart accounts for 32% of sales. This poses a perennial risk.
• More unsuccessful launches like Denise Austin
• Inefficient use of the $16.3mm of cash and securities
• Dual-class ownership and control of the board means management’s incentives are not always aligned with those other shareholders. In the past this has manifested in a number of troubling ways, one of which was a repricing of options in May 2001. The board may continue to agree to enrich management at the expense of diluting shareholders.

Catalyst

Catalysts
• Improved operating results in 2006 following the discontinuation of the Denise Austin line. Return to historical 14-15% EBITDA margins.
• Management decides to do the right thing and buy back massive amounts of stock (I wouldn’t be opposed to the company buying back all the Class A shares from Mssrs. Berman and Edell and doing away with the dual-class structure).
• Management decides to retire and sells the brand portfolio for a large premium
• If all else fails, this continues to be a very healthy, cashflowing business with a stable portfolio of performing brands with EBITDA earnings power of $8mm and normalized EPS of close to $0.70 per share. At some point, Mr. Market will catch up.